VoxEU Column Global crisis Monetary Policy

The ECB can make a difference if deeds match words

Many claim that monetary policy has hit diminishing returns. They use that as an explanation for the slower economic growth and low inflation in the Eurozone. This column argues that the main problem is that the ECB acted late and with half-measures to the Global Crisis, which was seen as falling short of its promises. The real problem is thus not a lack of ammunition, but a lack of credibility.

On 10 March 2016, ECB President Mario Draghi announced new measures to stimulate economic activity and raise inflation in the Eurozone (Constâncio and Draghi 2016b). The action was prompted by the worry that ‘core’ inflation, which strips out volatile food and energy prices, has remained stubbornly close to, or under, an annual rate of 1% since late-2013, well below the ECB’s goal of 2%. Indeed, the February reading of core inflation was 0.8% from a year earlier.

A controversy has emerged. The ECB now blames the fall in commodity prices for the extended deflationary tendency in the Eurozone and believes that it must press ahead with more action (Constâncio 2016). But some commentators despair that ‘central banks’ have run out of ammunition to further stimulate the economy (Bini Smaghi 2016, El-Arian 2016). Since the US Fed is plotting its exit from monetary stimulus, the ‘lack of ammunition’ diagnosis presumably refers mainly to the Bank of Japan and the ECB. So, what is the ECB’s challenge – overcoming the drag from commodity prices, or creating new ammunition?

The ECB’s commodity price-core inflation distraction

The ECB disregarded the decline in core inflation when it began in late 2013. In November that year, Draghi said that although energy prices had dampened headline inflation, monetary policy was working and inflation expectations remained “firmly anchored” at 2% (Draghi 2013). Even after the sharp fall in commodity prices that began in mid-2014, Draghi insisted inflation expectations were “firmly anchored”. 

At the December 2015 press conference, he acknowledged that the fall in oil prices had also caused core inflation to decline; and he now no longer claimed that inflation expectations were well anchored (Constâncio and Draghi 2015). Draghi announced new measures to stimulate demand and promised that the ECB would do more, “if warranted”. In January, with core inflation still refusing to budge, Draghi elaborated on the link between oil prices and core inflation: “… we have to take seriously the fact that low oil prices, low commodity prices for a long period of time may actually have second-round effects that we definitely want to take action against” (Constâncio and Draghi 2016a). But action was not warranted just yet. “It is clear,” Draghi said, “that the monetary policy measures that we have adopted since mid-2014 are working.”

On 10 March, Draghi did announce new measures, although these were diluted by his further statement: “We don't anticipate that it will be necessary to further reduce rates” (Constâncio and Draghi 2016b).

Thus, the recent ECB position has been ‘we got unlucky and are now responding to the commodity price fall in a measured way’. But is the decline in commodity prices the real reason for persistent low inflation in the Eurozone?

US-Eurozone inflation divergence

Despite differences in composition of the price indices, the US and Eurozone inflation rates moved remarkably in tandem from the start of the Great Recession in mid-2007 to late-2013 (Figure 1). In late-2013, a sustained divergence began. US core inflation stabilised at around 1.5%, while Eurozone core inflation began creeping down towards 1%. Importantly, this divergence occurred well before the large fall in commodity prices in mid-2014.   

Figure 1. Core inflation for the US and Eurozone

Note: 3-month moving average of year-on-year inflation

Once commodity prices began their sharp fall in mid-2014, US core inflation fell in tandem to a low of 1.3% in July 2015. Since Eurozone core inflation also fell during this period, it would appear that commodity prices can influence core inflation. But then US core inflation stabilised and rose again, reaching 1.7% in February 2016 over the previous February. In contrast, Eurozone core inflation continued its fall. Although up from its low point, the February 2016 year-on-year reading was 0.8%.

Thus the drag from commodity prices was felt only briefly in the US. Hatzius and Stehn (2016) estimate core inflation equations that account for persistence in inflation, economic slack, change in oil prices, and exchange rate depreciation. They find the following:

  • The recent oil price decline would have lowered US core inflation by about 0.2%, which coincides pretty much with the fall in core inflation from July 2014 to July 2015.
  • For the Eurozone, they conclude that the oil price impact was likely of the same modest order of magnitude. That drag, however, was offset partly by the simultaneous depreciation of the exchange rate, which tended to raise prices.
  • Eurozone core inflation tends to be much more persistent than in the US.

Thus, commodity price-core inflation story has been a distraction. The Eurozone’s decline in core inflation has deeper-rooted causes. The rest of this column expands on two related explanations.

The ECB’s loss of credibility

As we have earlier documented, the ECB’s too-little-too-late policy strategy caused it to lose credibility (Ligthart et al. 2015, 2016). Despite more frequent use of reassuring words since late-2011, the ECB’s delays and half-measures have continued into the present. Because ECB actions come late, they are seen as revealing more bad news or are discounted as insufficient to deal with the problem that, by then, is more deeply entrenched. A policy measure not taken on time is a policy measure not taken. Monetary policy has not run out of steam, as some observers despair. Rather, the ECB has rendered itself ineffective.

Consider the evidence. The ECB fell behind the curve at the very start of the Great Recession, and never caught up. While the Fed aggressively cut rates starting in September 2007, the ECB waited and then raised its policy interest rate in July 2008. Only after the Lehman Brothers-induced near meltdown in September 2008 did the ECB begin gingerly lowering its policy rate.

In the summer of 2010, even though headline prices were rising during the brief economic rebound after the 2008-9 collapse, the Fed started pre-empting deflation. The Fed’s risk-management approach – adopted at first to prevent an output collapse – was extended to pre-empting deflation (Federal Reserve System 2010). Many European policymakers warned at the time that the Fed would stoke inflation. But financial markets understood what the Fed was doing and at Jackson Hole in August 2010, an analyst said: “The thrust from Bernanke will be on what the Fed could still do, while the message from Trichet is that we have done all these measures and they appear to be working” (Kennedy and Lanman 2010). The difference between the two central banks was stark: while the Fed was worrying about deflation, the ECB was unable to stop agonising about inflation. Twice in 2011 the ECB raised interest rates.

In late-2011 under the new President Mario Draghi, the ECB’s language changed but actions were, as before, delayed. Our analysis documents that markets continued to be disappointed by ECB’s actions. With core inflation approaching 1% in November 2013, Draghi insisted: “a [possibly] prolonged period of low inflation [would] be followed by a gradual upward movement towards inflation rates below but close to 2% later on.” The medium term outlook for inflation expectations, he said, remained “firmly anchored”. The new ECB mantra was that more would be done “if needed” (Draghi 2013). In April 2014, Draghi said that the ECB would act but only if inflation remained low for “a too prolonged period” (Draghi 2014). When asked what he meant by “a too prolonged period,” he dodged the question.

To be clear, the ECB did take a number of stimulus measures starting in late 2011. But because every ECB action was always reactive, it was viewed through the lens of ‘why not more’. The finding of Hatzius and Stehn that Eurozone inflation is much more persistent than in the US reflects the delayed ECB responses.

Persistent effects of austerity

Weak demand has been the other important influence on core inflation. The Eurozone’s monetary and fiscal austerity (along with the strategy of internal devaluation) have caused demand and, hence, core inflation to fall; this is so especially in the most stressed countries. Between 2011 and 2016, the average annual rate of core inflation varied from negative 0.3% in Greece to 2.4% in Estonia (Figure 2). Even if we treat Greece as exceptional, Irish and Cypriot core inflation have averaged 0.7% over this period.

Figure 2. Real import growth and core inflation

Note: ‘Core’ inflation is measured as HICP excluding energy and unprocessed food; ‘Real import growth’ is from the IMF’s World Economic Outlook.

To explore the influence of weak demand, we use a summary measure of austerity-cum-internal deflation: growth rate of real (inflation-adjusted) imports. Fiscal austerity and internal devaluation both act to reduce imports. Figure 2 plots core inflation against real import growth. It is striking how this one explanatory variable can explain so much of the cross-sectional variation: countries with higher import growth have experienced higher core inflation. 

In sum, with policy-induced contraction of demand and monetary policy lacking credibility, it is not a surprise that low inflation has been persistent in several member states.

Where next?

Hand-wringing about ‘diminishing returns to monetary policy’ misses the point. US monetary policy achieved its purpose with hitting diminishing returns. The ECB’s strategy ensured that the returns would always be low. ECB policy announcements have, at times, caused a brief flutter, but they have had little traction.

The success of monetary policy depends centrally on whether it can change expectations. And that, as Blinder (2012) emphasises, requires the central bank to match its deeds to its words. The Fed’s proactive measures were accompanied by a signal that more was in the works. Deeds did match words. The ECB acted late with half-measures, and these were perceived to fall short of its promises.  

So, no, the Eurozone’s fall in core inflation is not being driven by oil and other commodity prices. The real problem, indeed, may be that the ECB has lost the ability to do much about the disinflationary trends. But lack of ‘ammunition’ is not the problem; lack of credibility is. The prognosis is not good. If, as is likely, the Chinese economy continues to slow, world trade will remain weak and, hence, Eurozone growth will remain anaemic. With persistent low inflation, the burden of debt will remain high, which will further drag down domestic growth and perpetuate the debt-deflation cycle. The Eurozone will need more fiscal stimulus, and the ECB will need to match its words and deeds. Otherwise, the debt-deflation process will drift to its natural, if frightening, culmination.


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